Trading Commodities Online
What is a Commodity?
A commodity is a physical product that is typically bought and sold in an established financial exchange, for example the Euronext. However, retail traders can also trade commodities on a CFD trading platform. Regardless of which producer produces a commodity, it maintains uniformity even though there may be slight differences in product quality. The commodities can be broken down into four main categories: precious metals, non precious metals, energy and agricultural. Some of the most popular commodities include:
- Metals (precious and non precious) – gold and silver
- Energy – crude oil and natural gas
- Agricultural – corn, cocoa and milk
How are commodities traded?
Commodities are usually traded on the futures market through futures contracts. These are short term contracts with definite expiry dates. In a commodity futures contract, the seller agrees to deliver an agreed quantity of a commodity at some date in the future at a pre-determined price. The buyer agrees to buy the product and to make payment by the agreed upon date.
The futures market is the exchange that connects the sellers of commodities with the buyers. Therefore, anyone seeking to trade in commodities may purchase a futures contract through a commodities broker. To establish a contract, a minimum deposit must be paid and a brokerage account would be established for the trader. Since commodity prices are always changing, the value of the brokerage account will change during the contract period. If the value falls below a certain level, the broker will make a margin call, requiring the account holder to deposit additional funds into the account to maintain an open position. Usually, these accounts are highly leveraged which means that small changes in price will result in huge potential profits or losses. This is one of the characteristics that draws traders to commodities.
Commodities may also be traded indirectly through the equities market, through mutual funds, through exchange-traded funds (ETFs) or through a contract for difference (CFD).
Unlike manufacturers, most traders do not want the actual delivery of the commodity they are trading, therefore a commodities trader will usually opt to roll-over the futures contract for that commodity. A commodities roll-over effectively extends the expiration date for the settlement of the contract, allowing the trader to avoid the costs associated with the settlement of an expired futures contract.
Commodities trading with CFDs and leverage
Commodity trading is a popular choice for traders because of the increased upside (and increased downside) potential offered by the high leverage usually offered on commodities.
What this means is that the trader can start off with a smaller deposit to trade but he can make multiples of his investment if the commodity price moves in a favourable direction, however, the opposite is true if the market moves against the trader and losses can be magnified. The broker essentially lends the trader the remaining portion of the actual commodity value, this will usually be charged an overnight financing charge. For example, popular CFD broker CMC Markets will charge an overnight fee + / – 2.5% annual charge above or below the relevant base rate.
For example, let’s assume you buy a commodities futures contract for gold, where the Cost per ounce of gold = $1,000.00.
You agree to 2 contracts at a weight of 100 ounces per contract.
The full contract cost = $1,000 x 2 x 100 = $200,000.
You make a margin deposit of 6% which is (0.06 x 1,000 x 2 x 100) = $12,000.00.
The broker is technically lending you the difference of $188,000.00.
Let’s assume the price of gold increases to $1010 per ounce
Profit = ($1010 x 200) – (200,000) = $2,000, return = 2000/12000 = 16.67%
So, with an account balance of $12,000, you would have made a profit of $2000 (16.67%) with just a 1% price increase.
However, it is important to note that if the price had fallen by the same amount, you would have made a loss of 16.67% with just a 1% fall in price.
Summary: Why traders chose to trade commodities with CFDs
Leverage and smaller contract sizes are two factors that attract traders to trading futures contracts as CFDs (contracts for difference) rather than traditional trading. With a combination of smaller contracts and leverage, the intitial capital requirements for traders is significantly lower.